Saturday, June 30, 2012

Macro: people vs. institutions

The macroeconomics [centrist dodge] looks like this: a concerned writer or speaker on economics bemoans the state of the field and argues that what we really need are macroeconomists who are willing to approach the subject with an open mind and change their views if the evidence doesn’t support their model. He or she concludes by scolding the macroeconomics profession in general, which is a nice safe thing to do – but requires deliberately ignoring the real nature of the problem.

I don't want to be arrogant enough to think that people are noticing a small-time blogger such as myself, but...perhaps one of those "concerned writers" is me? I did say this, after all:

The root problem here is that macroeconomics seems to have no commonly agreed-upon criteria for falsification of hypotheses...So as things stand, macro is mostly a "science" without falsification. In other words, it is barely a science at all. Microeconomists know this. The educated public knows this. And that is why the prestige of the macro field is falling. The solution is for macroeconomists to A) admit their ignorance more often (see this Mankiw article and this Cochrane article for good examples of how to do this), and B) search for better ways to falsify macro theories in a convincing way.

Krugman writes that good macro evidence exists, and that the reason some people have refused to accept it is because they are political conservatives:

[I]t’s not hard to find open-minded macroeconomists willing to respond to the evidence. These days, they’re called Keynesians and/or saltwater macroeconomists...But then there’s the other side – freshwater, equilibrium, more or less classical macro...rather than questioning its premises, that side of the field essentially turned its back on evidence, calibrating its models rather than testing them, and refusing even to teach alternative views.

So there’s the trouble with macro: it’s basically political, and it’s mainly – not entirely, but mainly – coming from one side.

This seems to me to be pretty much true. Some economists are politically conservative. They don't like government intervention in the economy, so they want to reject "Keynesian" or "saltwater" theory, which says that government has a constructive role to play in stabilizing business cycles. So they want to believe in other models, models where business cycles are driven by things like technology shocks or government policy or "Great Vacations". Unfortunately, those "neoclassical" models have a very hard time getting pricesto go down when a big recession hits. And they have a very hard time getting interest rates to stay low even though the Fed prints a bunch of money. So conservative economists basically tend to ignore the behavior of prices and interest rates during episodes like the current one.

So I think Krugman is right. Most of what looks an awful lot like willful ignorance of the evidence generated by the current crisis seems to come from political conservatives. Meanwhile, other macroeconomists have shown a lot of willingness to change their mind about the world since 2008.

BUT, I think Krugman fails to address a bigger question: How did things get this way? How did neoclassical macro become the mainstream in the first place? One answer is that it's all down to money - departments like Chicago, Washington University, and Minnesota, according to this argument, were funded by people with politically conservative views, and these institutions basically became political propaganda mouthpieces.

I don't know how much truth there is to that. There are certainly instances of conservatives providing funding to a department known for its outspoken political conservatism - take, for instance, George Mason University, whose econ department is heavily funded by the Koch brothers. And I know that Washington University macroeconomists get paid nearly twice what their counterparts at places like Michigan get paid (it's a pretty sweet gig!). So I don't discount the possibility, I guess.

But conservatives do not fund the Nobel Prize committee. Rich donors did not pressure a bunch of Swedish guys into giving big gold medals to Edward Prescott and Robert Lucas, the fathers of neoclassical macro. Nor do shadowy conservative gazillionaires own the AER or the JPE or the QJE. Journal editors' arms are not being twisted into publishing models based on technology shocks.

Instead, I think what happened was that the neoclassical people made an argument that sounded convincing at the time (the 70s and 80s), and the field bought it. And the field bought it because there are just no agreed-upon ways to falsify or support macro theories with data. This is not to say there exist no such ways. Data was not kind to Prescott's 1982 RBC model. But that was not considered sufficient grounds for the profession to reject the RBC idea. Macro is just not a profession where people say things like "Hey, inflation goes down in most recessions, this RBC thing can't be right!" It's a profession where people say things like "RBC is telling an interesting story that doesn't seem to explain the Great Depression, but seems like it could explain the stagflation of the 70s, but more importantly it developed a methodology that we all now want to use (DSGE), so let's give it a Nobel Prize."

And that, I think, is the bigger problem. Macro doesn't just have a bunch of conservative people running around being conservative. It also has broken institutions. Without a firm commitment to rejecting wrong theories, and without agreed-upon standards for doing so, it's very hard to overcome the politics. Sure, you can get a gang of liberal-minded people together and try to push back against the conservatives, but in the end the best you can hope for is a bitterly divided profession, resulting in a massive loss of prestige in the eyes of microeconomists and of the educated public. Which is exactly what we have now. It's not liberals' fault, there's just not much they can do to fix the situation.

If the data does not speak, bad ideas will persist. And without the proper institutions, the data will not be allowed to speak.

My thoughts go back to what Larry Summers said about regulators when interviewed at Bretton Woods by Martin Wolf. They hadn't had a crisis in a while so they got complacent. Conservatives are complacent.

It may take time for the lessons and data of the recent crisis to set in. It's like with Minsky and banks irrationally taking on leverage and debt as boom turns into a bubble.

My hope is that more younger students, professors and policy makers will look at the data more objectively and less ideologically. Of course some will be lured away from objectivity by big paychecks or by grudges against liberal hippies.

"Data was not kind to Prescott's 1982 RBC model." Ask yourself why? Ask yourself why the profession is dominated with students of Lucas, Prescott, Barro and their followers of the Minnesota cult. Where are the students of Krugman, DeLong and even Tobin? It is like when Bill Maher says Mormonism will one day be the only religion of the US

I do ask myself this, but I don't have a good answer. I do think that the lack of scientific standards is a necessary factor, as I've said many times, but I don't think it's sufficient. Why did the Lucas/Prescott/Barro gang do so well?

You're just an Asst Prof... you will get your answer once you try to publish. Just go through the list of JME editors. Unless Miles_Mankiw pull strings for you, you will realize that journals are clubs that make rigorous concerted efforts to remain exclusive to what SW calls "serious (SED) macro." All else, as they say, is junk... Good Luck!

Yes I know this. Fortunately for myself I am an assistant prof in finance, and I happen to buy into the orthodox viewpoint there, since I believe in the weak form of the Efficient Markets Hypothesis (I'll do a post on this at some point). You didn't think I'd spend all this time bashing macro if I intended to publish macro papers for a living, did you?

Incidentally, if you want a nice disproof of the EMH, spend your time arbitraging RDS.A and RDS.B, which both represent the same percentage of the same company. It is possible to make money on this even while eating the transaction costs. There is *no possible reason* for the price variation other than crap investors, but it's consistently there, one way or the other.

And then there's failure to analyze. Technical analysis may seem like voodoo, but it can work in the short term because it's capturing psychological trader behavior -- systematic non-rational behavior -- in the aggregate. This disproves the weak EMH. Of course, any *popular* technical analysis is unlikely to work, but if you figure one out which others haven't figured out yet, it probably will work.It never works in the long term, but everyone knows that.

The thing is, how much do you have to weaken the EMH in order to fit the data? It seems like you have to weaken it to the point where it says "people will take advantage of arbitrage opportunities if they spot them", which is an uninteresting truism.

I should note that I believe in a different hypothesis: the "paying for active management is worthless" hypothesis.

I believe specifically that whenever someone does know how to beat the market, they will charge enough so that if you attempt to beat the market by hiring them, you will not beat the market. (Exceptions may exist if the person has some other relationship to you.)

Therefore the only way to beat the market is to spend a lot of time and energy on research. Yourself. Will the cost of that time be more than you gain by beating the market? Probably. So only do it if you think it's fun!

How did things get this way? How did neoclassical macro become the mainstream in the first place?

The Keynesians rolled over and did not stand up to the criticisms based on stagflation. By exiting the playing field, they created a vacuum that was occupied by the likes of RBC which has far worse assumptions, is far less robust and far less consistent with the data. The assumptions of RBC made it easier to model and easier to apply the advances computing technology. However, as the computer geeks say, Garbage In, Garbage Out.

Better data on consumer spending, the effects of young baby boomers women and blacks entering the job market and oil shocks could have made the Keynesian model look far less bad and as good as, if not better than RBC. That did not happen and instead, Macro has spent 3 decades wandering about the RBC wilderness. The RBC tribe will never give it up.

Money is not the only answer, but money buys influence. People with money fund artists that they like and economists who tell them what they want to hear. People with money can fund awards that promote ideas they like, they can buy media to promote books they like, they can fund total disinformation campaigns to serve their purpose. Money will make it difficult to ignore the recent past and rebuild the models from better assumptions. However, the task is to build new models and new institutions to support the people who will build them.

BTW: Is the picture supposed to represent the institution of slavery fighting the will of the people?

For whatever it's worth (and I'm not an economist, just a voyeur, so it may not be worth much), when I read your post the other day about how macroeconomists should basically admit that the Great Recession has rendered them clueless, my instant reaction was "boy, this is going to burn Krugman up if he reads this" -- and that was even before I got the part where you link to Mankiw and Cochrane.

And when I read Krugman this morning, my instant reaction was "oh, he's talking about Noah Smith." He does link to you now and then, as you may have had occasion to notice, so it's not entirely far fetched that you were a secondary if not a primary target. Regardless, I greatly enjoyed reading your additional thoughts today.

I don't see a failure of Macro, even if I see undue curruption coming from ideological depts, finance depts and Bschool (much the same thing) and from the fallacy of looking for a scientific approach that attempts at theory through micro-foundations that build to macro. When dealing with human behavior, individual or aggregate, models are only tools for turning intuition into analogy but in a language with more rigor, they can never approach theory and what they seek to explain should and can only be events both ephemeral and past. If we're lucky, they may be instructive in helping to quickly understand events of the future, but that should never be their primary use, that relm belings to the fools in finance. There need not be any scientific principals of falsification that resemble hard science, something economics will never be; all there need be is a principal that any model of set of models, from their simplest to their most complex iterations, fit empirically with the data and observations of the time period and place it seeks to explain using the language of mathematics so that the explanation is rigorous and can be manipulated. There can never be a universal theory of economics or anything involving human behavior, indeed, you can never produce a theory of any soft in these realms. Tools are only useful if you know they're tools and that they will require supplementation if you intend to explain much of anything.

This is rather like saying climatology has the problem, because conservatives are willing to throw lots of money into obfuscating the science for political gain. The solution isn't to call out the profession for being sabotaged, it's to call out the saboteurs for inflicting mass harm for political gain.

Facts are pesky things. Within 10 years climate change caused by human CO2 emissions will be so obvious that people denying it will be laughed at in the streets and probably have rotten fruit thrown at them.

Noah, as you know, my answer to “how did it get this way?” is to bring micro into the story too. The anti-Keynesian revolution was about so-called microfoundations. One criticism, a true one, is to say that it was phony micro, since representative agents are mythical aggregates, not the actual subjects of real, gods-honest micro. But the other, which I think is also true, is that what these mythical agents are supposed to be doing is also problematic. Utility maximization is both a positive and normative hypothesis. Used for positive purposes, like microfoundations, it also embodies a normative presumption of what good economic outcomes are: those that reflect the U-maxing choices made by these agents. You have to introduce specific wrinkles to drive a wedge between private choices and public benefit to get any other result. New Keynesians did this, but one wrinkle at a time. This meant that market outcomes were almost optimal, subject only to a bit of tweaking.

I would regard this as inherently conservative; there is no need for conspiracy or bribery theories. New classical econ ruled the roost because it seemed joined at the hip with micro and could therefore appropriate the markets-are-mostly-wonderful bias of the latter, which had already become the hegemonic view within the profession. In other words, macro is not special; its place in social and political discourse is of a piece with economics in general.

And micro is, if anything, even more outrageously impervious to falsification than macro. As a microeconomist, I can only say..... grrrrrr!

I agree with this post. I sure didn't think of you (at all) when Krugman questioned centrists (in fact I thought of Wren_Lewis to whom Krugman linked and praised). I agree that the problem is fumdamental -- a theory which doesn't fit the data at all can be considered excellent economics. The basic methodology used by natural scientists is not used at all.

I do have one point of disagreement. You bring up the Nobel Memorial Prize in economics. Your discussion of the history of the award does not discuss the "bunch of Swedish guys" at all (for example by naming one or two of them). The Nobel Memorial Prize in Economics is awarded by a committee not by the profession. To understand it, you have to understand the committee, which is made up of people.

In particular the Nobel committee's idea of what is excellent economics changed completely when Asser Lindbeck ceased to be chairman of the committee. I think you should address the question of whether the prizes going to professors at the University which gratned Lindbeck his PhD (Chicago) had more to do with the spirit of the profession (the pfofeziongeist ???) or with Lindbeck's political views. He is very outspoken. You can't be around him for 5 minutes without knowing his ideological orientation.

Now I admit a committee is not its chairman. But the pattern is very clear. The profession decided to focus on people like Kahneman and Sen rather than Lucas, Becker and Prescott very suddenly. I think much can be explained by considering two people -- Assar Lindbeck and Lars Svensson.

Of course this is a side issue. The Nobel Memorial Prize committee is immensely influential (note you identified it with the profession) but it isn't everything. It is a fact that the profession considers Lucas and Prescott to be great economists. It is a fact that hypotheses which strike non economists as absurd and which are rejected by the data for exactly the reasons non economists (or at least first year graduate students in economics) imagine is considered a great contribution.

I think I agree with you that the problem is much broader than Krugman suggests. Many New Keynesians too treat economics as a branch of mathematics and don't consider fitting reality without one arbitrary parameter for each phenomenon to be explained to be necessary. Krugman is not one of these new Keynesians. I think wrote strategically and is trying to form an alliance of all salt water economists (including the math addicts).

Not sure why you think that "freshwater" economists are dominant. My impression is the exact opposite.

It might be more interesting to try to explain why Krugman tilts at this windmill with such regularity rather than directing his lance at people with genuine influence, like his fellow saltwater buddies running the Fed, the ECB, the WB, the IMF...

There is no Nobel Prize in economics. And by that I'm not referring to the fact that its equivalent goes by another name. I'm referring to the fact that the honorees of that prize are selected by a committee of BANKERS. As such, what we have is a Nobel Prize in Banking, not economics. And freshwater economics has been very, very good for the bankers, hasn't it.

You should give Frederick Soddy and Arthur Kitson a good read. Might give you some insight into why there is such a disconnect between micro and macro. The dominating economic schools are not economics at all. They are just chrematistics - the study of wealth in terms of money. But economics is not just about money, for money is just a creation of the human will, a debt. All physical sciences are based on real phenomena. They are testable and use standard weights and measures. Those that want economics to be treated as a real science must seek to base it on something real and measurable. Money, as it is right now, has no standard of value. The reason for this at the macro level is because money is issued by private banks at interest. The interest can not be repaid unless more money is issued, once again at interest. This is different from interest made on the loaning out of savings. The conclusion is that "some inflation is good". Not because it actually is good, but because it is absolutely required when money is rented out. Once money is issued in this way, it can no longer function as a standard of value and all hope of economics as a science is lost.

I wish Soddy was required reading in economics classes today. The biggest confusion in economics is the one between wealth and debt.

in once sense relativity teaches that there is no standard of value and yet physics is a science

similarly, the cat may be either alive or dead, but quantum mechanics is still a science.

thus, there is no "rule" that money need have a constant value for economics to be science.

for economics to be a science as discussed by Noah, it must be based on experiments and experience and observation.

That is the problem with macro economics, which Noah correctly arguments has institutional failure. We have lots of experiments, experience, and observation from which we know a great number of right wing economists are wrong, yet they remain in the trade.

Take a simple science experiment: boiling frogs. If you raise the temperature too fast, the frogs jump out. From this experiment on can leave a rule about the psychology and physiology of frogs: if you raise the temperature faster than x over t, etc., the frog will recognize the heat and jump out.

People change their behavior based on expectations, which depends, in turn, on their ability to observe and process information.

Under some circumstances, people believe that if they build a new business, customers will come.

Many many businesses do not believe this under present circumstances.

There are well known causes and solutions, but because of the politics, we are not about to get solutions.

We know from the science of economics that Krugman is right. We also know from the science of economics that oil price shocks started the mess and the gaining control over oil prices is a key to restoring financial stability. Last, we know that we need massively increased immigration of young people, because are demographics are all messed up. Future job growth mostly depends on much more robust long term population growth. We know all this from observation.

And yet, we have have the country that wants to end immigration and send 12 million people (+/-) away. At 2.x people per household, or what ever, that is how many vacant housing units. How truly stupid and self defeating a program or policy.

We also know from observation that there is no Ricardian (Barro) Equivalence, no Laffer curve, no Taylor rule, I could go on and on and on, but basically the right wing is BS.

May I suggest the Feynman lectures, at Cornell, especially the entire 7th lecture

Looks like you are fully confused by what science means. The physical sciences have experiments, but the experiments would be useless if they could not be quantified. A meter is a meter. It is measurable and never changes. Money today is not the same as money tomorrow. Boiling frogs is not a quantifiable experiment. It's an interesting little study, but not scientific.

Imagine kilometers today actually measured less tomorrow but were still called kilometers. So one kilometer today might be a half a kilometer tomorrow, but it is still considered one kilometer. A car going 90 kilometers per hour today may actually be slower than a car that went 70 kilometers per hour at a time before. This does not change the fundamentals of physics. Force still equals mass times velocity. It just makes reading the results of any experiment totally confusing. The purpose of science is to help us understand and explain the world around us.

So before you can even do an experiment, you must have a standard measure. Money is like the kilometers in the example above. It's value is not controlled by the community that must redeem it. It's value is continually devalued to pay for interest on the previous issuance of money. We pay rent on money and we know from Ricardo that rent is simply the power to take part of the results of production. Private banks own the money even though it is society that must redeem it with goods and services. This has created an idle financial class living off the production of society.

Society needs to seek continual growth to pay for previous debts on the issuance of money. To do this it must seek more capital which simply creates more debt. This is why increases in productivity do not lead to more liesure time and society must continually work more rather than less.

You mention that we need job growth, but why do economies continually need to grow? Economies grow with population growth, but if a population is stable, why does it need continual growth?

There is no need to study the rats nest of chrematistic economics when it has no sound base to begin with.

Krugman certainly does notice "a small-time blogger such as" you, since he's mentioned you a few times that I can recall. When I read that post, I thought of you, but it was clear he was *not* talking about you.

As an old atmospheric chemistry modeler, I know that it is very easy to tweak a model toward the data rather than revise it, even in the face of obvious problems. I think Krugman's case is that simple models are the best because we can understand what they they are telling us--and what they are not. The more complex a model, the less useful it is in understanding systems.

I don't know economics, but is it possible that there is a kind of "last war" thing going on here? People accepted Keynesian economics after the Great Depression because that formalism worked for it. When RBC worked well to explain stagflation, it was what everyone believed. And right now the situation is still working itself out but whatever wins this academic war will be in favor until the next unexpected crisis. Maybe?

I hope this isn't off topic, but it seems like part of the lack-of-agreement-on-falsification you're referring to is connected to the issue of calibration vs. testing. Could you explain, or point to an explanation of, what calibration entails and what is wrong with it? Specifically, how is calibration a way of evading potentially falsifying tests?

Interesting topic, Noah. But testing macroeconomics is a hard nut to crack. I cannot recall any hypothesis formally rejected by good-old Keynesian Macro despite much devotion to macro-econometric models. That was unsatisfactory, and Lucas got lots of ayes pointing to it. His (and Prescott's) answer was to forget about testing and focusing on approximate "replication" of selected statistical moments. It was nice while it lasted. But we are now again at the starting point, with the obstinate nut and no nutcracker. Why is that nobody brings the nutcracker? The elders would say that testable Macroeconomics is an oxymoron: no way you can formulate sharp hypotheses with Macro models, you will end stuck with auxiliary untestable propositions like individual rationality. But, who knows, maybe there is some graduate student toying with the right nutcracker that will convert him in Macro's Einstein. I wouldn't bet on that.

The process for using models is as follows.1. Ask a question in a verbal language2. Translate the verbal language into mathematical language3. Perform the calculations4. Translate the results back into verbal language

In order to do 2, translate verbal language into math, simplifications and assumptions must be made. Every process contains assumptions. Nuances and more are lost in translation. A major problem is inappropriate use of models, when the models make critical assumptions that are not valid or not currently valid.

For example, many models assume full employment or that a depressed economy will rapidly return to full employment. This assumption violates current economic conditions. Thus, using a model that assumes full employment tells us nothing about the policy needed to return an economy to full employment. Much of the whacko current debate is over the concept of full employment including idiotic statements about labor wanting a vacation. Other arguments include, "policy can do nothing to affect unemployment" which is contradicted by a lot of data. These arguments are over the economic facts. The argument made is the facts must be wrong because the model assumptions are violated. These arguments come to bad conclusions because they are based on invalid, falsifiable assumptions.

Unfortunately, there are too many who stick to their models in spite of the critical flaws in the assumptions. Flawed assumptions and lack of model validation should be a signal to be quiet and go work on the model. In this debate, flaws and invalid assumptions have been repeatedly discussed, but the response to valid criticisms has been to argue the facts instead of fixing the model. Close-minded people trumpeting flawed assumptions and models are detracting from the conversation. Models that do not have flawed assumptions and are producing valid predictions under the current conditions and should be the focus of discussion are dismissed out of hand and lost in the noise.

Falsifiability, invalid assumptions and models that cannot be validated should all be ingrained in the culture of economic policy discussion and acceptable rules about who has a credible policy and who does not. Invalid model assumptions should be reason enough to exclude a policy recommendation from the scholarly discussion and the person politely told to stay out of the discussion and come back only when the assumptions are squared with conditions. The non-existance or violation of these norms, often by acclaimed scholars, is corrosive to the discipline.

Sargent, Sims, Kehoe and even Steve Williamson are all Democrats. That's some evidence against the complaint about those awful right-wingers from Minnesota, but is compatible with your complaint about institutions sticking with a faulty paradigm.

yeah, perhaps the disagreement can be dissolved if we take into account Mankiw's statement that the mainstream of economics is now "brackish". Saltwater economists have read freshwater economics and incorporated parts of it. So someone like Williamson can scoff at the proposed division he says doesn't exist any more, though there still may be freshwater purists ("scientists" rather than "engineers" in Mankiw's terms) who remain out of policy-making bodies like the IMF.